The IRS has released final like-kind exchange regulations (T.D. 9935
). The final regulations take a more taxpayer-favorable approach to defining real property than provided in proposed regulations issued in June. They are generally effective for exchanges beginning after the date on which they are published in the Federal Register. Taxpayers that were planning an exchange and relying on the proposed regulations should re-evaluate the exchange in light of the changes made in the final regulations.
Prior to the Tax Cuts and Jobs Act (TCJA), Section 1031 allowed exchanges of property, within a class, for other property of the same class (e.g., automobile for automobile, or real property for real property). Property involved in a like-kind exchange is generally eligible for deferral of gain on the transaction, which makes it a helpful tax planning tool. The TCJA amended Section 1031 and limited this favorable treatment to only include exchanges involving real property.
The proposed regulations narrowly defined real property as land, buildings and their structural components (inherently permanent structures). Such definition was specifically without regard to state law. They also provided a “purpose or use test” to exclude certain property, like machinery and equipment, if the property contributed to the production of income that was unrelated to the use or occupancy of space. For example, a plumbing connection for a piece of machinery in a manufacturing facility would fail the purpose or use test and would not constitute an inherently permanent structure (i.e., it would not be considered real property).
The final regulations significantly modify the definition of real property. Taxpayers may now rely on state law in effect as of the date of the exchange to determine amounts that are real property, but continue to exclude certain intangibles regardless of state law treatment, such as stock in a corporation or ownership interests in a partnership. The final regulations also remove the purpose or use test. Therefore, tangible property dedicated to machinery used for the production of income may now be considered real property for purposes of Section 1031. Finally, the regulations provide certain specific items that are considered real property. If an asset is not real property under state law and is also not specifically listed, then it may still be considered real property for Section 1031 based on a consideration of all the available facts and circumstances.
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